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Sovereign Debt Crises

Sovereign Debt Crises

A Problem of Debt Management?

Chapter:

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2 Sovereign Debt Crises

Source:

Sovereign Debt and Human Rights

Author(s):

Rosa María Lastra

Vassilis Paliouras

Publisher:

Oxford University Press

DOI:10.1093/oso/9780198810445.003.0003

Abstract and Keywords

Creditor responses to sovereign debt crises suggest that they view such crises as problems of debt management on the part of the countries facing debt repayment difficulties. Thus, for example, debt relief and restructuring mechanisms coordinated by the international financial institutions place emphasis on correcting perceived imprudent debt management through a series of economic adjustment measures. Little attention, if any, is paid to addressing the underlying causes of the debt crises. This chapter examines the various causes of sovereign debt crises and the role that debt management plays in their eruption or in addressing them in a sustainable manner.

2.1 Sovereign Debt: Blessing or Curse?

2.1.1 A short history of US public debt

In January 1790, Alexander Hamilton, then secretary of the US Treasury, submitted to the House of Representatives his ‘Report Relative to a Provision for the Support of Public Credit’, better known as the ‘Report on Public Credit’. Therein, Hamilton declared that ‘the proper funding of the present debt will render it a national blessing’.1 This was in sharp contrast to James Madison’s famous aphorism that ‘a public debt is a public curse’.2 History certainly vindicated the prominent Federalist statesman, as America’s rise to the status of global superpower is difficult to imagine without the system of public credit that Hamilton devised.3 Yet, as the above quotes aptly illustrate, Hamilton’s views on the role of sovereign finance as a tool for economic progress sparked a fierce controversy between Federalists and Republicans in the newly established American republic. These debates, although often infused with the polarization of the era’s political atmosphere, speak to the heart of the policy dilemmas raised by sovereign debt: democratically elected politicians seem to have an almost irresistible bias towards borrowing, given that their constituency will benefit from increased spending, and then merely pass the bill to the next generations.4 These generations, however, were never consulted, because the decision to borrow was taken when they were yet unborn or too young to have a say.5 Why, then, should politicians ever be allowed to ‘borrow now and tax later’? Or, perhaps more controversially, to what lengths should governments go to pacify the bond market and build their credit? How should the trade-off between efficiency and fairness be resolved? Needless to say, these perennial questions come with no easy answers. Nevertheless, the intellectual history of US public debt might at least offer some guidance.

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In the aftermath of its revolution, the US was a rich but cash-strapped state. In order to fund the war effort, the Continental Congress had issued en masse continental dollars, which quickly lost most of their value and eventually became worthless.6 This created an immediate need to establish a strong reputation in the investor community and build the new republic’s credit. Hamilton and the Federalists were of the view that the best way to achieve this was by allowing the federal government to assume responsibility for the debts of individual states. Thereby, US$18 million of state-owed debt became the obligation of the federal government.7 To be sure, the federal assumption of state debt was not the equivalent of a massive creditor bailout; rather, it was accompanied by a large-scale debt restructuring operation. Both foreign and domestic creditors were offered instruments with reduced interest rates and renegotiated terms of payment.8 Perhaps the most controversial part of Hamilton’s debt operation was the fact that US public debt became effectively ‘perpetual’. In particular, while the original securities had been issued either with a fixed maturity date or under the assumption that Congress would repay as soon as was practically possible, the new instruments took the form of redeemable annuities without a specified maturity.9 Creditors were thus entitled to a secure stream of interest revenue, but the repayment of capital was apparently postponed in perpetuity.10

The Republicans, led by Thomas Jefferson and James Madison, voiced principled opposition to Hamilton’s report on public credit. Although strengthening American creditworthiness was an aspiration that garnered bipartisan support, Jefferson had a radically different opinion as to how this should be achieved. In Jefferson’s mind, deficit finance was objectionable on grounds of principle. He declared that ‘the earth belongs in usufruct to the living’, and if the second generation was not born free of debt, then ‘the earth would belong to the dead’.11 In terms of debt management, this translated to the ambitious goal of redeeming the totality of US public debt within nineteen years.12 Jefferson was quite explicit on the immediate need to reduce US public debt: ‘I would wish the debt be paid tomorrow’, he said; in contrast, ‘he (i.e. Hamilton) wishes it never to be paid’.13 Republican concerns about the sustainability of US public finances were not entirely overblown. Hamilton’s plan for perpetual public debt arguably contrasted with contemporary English best practices on debt management under William Pitt. These practices consisted in the establishment of a sinking fund where payments towards the replenishment of capital were regularly made.14 Of course, the Jeffersonian critique of Federalists’ attempts to consolidate America’s public debt was much deeper. In writing to George Washington, Jefferson claimed that the ultimate purpose of the federal assumption of state debt was to undermine the Constitution
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and establish a monarchy following the British model.15 To him, Hamilton was purposefully avoiding extinguishing the debt in order to create a political constituency of public creditors that would be subsidized by the taxpayer.16

At this point, the heated debates of the US founding fathers should have already revealed some of the most salient issues involved in sovereign debt management. Questions of intergenerational equity and burden sharing, and also concerns about the danger that the federal government would mortgage its autonomy to bondholders, immediately became pressing after the federal debt assumption.17

The debt restructuring that accompanied the assumption, on the other hand, brought to the fore the distributional consequences of restructuring, and, more broadly, the associated trade-off between fairness and efficiency. A major principle upon which the restructuring operation was based was that of non-discrimination and contractual sanctity.18 According to Hamilton, ‘[discrimination in paying off debt] is inconsistent with justice, because in the first place, it is a breach of contract in violation of the rights of a fair purchaser’.19 In declaring the inviolability of contract in that juncture, what Hamilton had in mind was the right of bondholders that had purchased script of the revolutionary government at deep discounts to their face value while hostilities were still pending to full repayment. The original holders of this debt had involuntarily received it in the form of IOUs from the revolutionary government as payment for services to the revolutionary army, or as compensation for the requisition of private property.20 Madison and the Republicans wanted the original creditors that had directly contributed to the war effort, but were forced to liquidate their holdings in the harsh economic times of the revolution, to receive some compensation, even if that meant that secondary market purchasers were not paid at par.21 Hamilton, however, believed that any interference in the secondary market for US public debt would cause irreparable damage to the government’s credit.22 Eventually, Madison’s proposal was defeated in Congress, which sided with Hamilton’s view that, in light of the newly established republic’s urgent need for cash, pacifying the bond market ought to take precedence over any considerations of fairness.

The legacy of Hamilton’s report on public credit, which became federal law under the Funding Act on 4 August 1790, is, without doubt, a positive one. To be sure, in an era where the great bulk of the federal budget was committed to military expenditure, sovereign
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finance conveniently served as an ‘instrument of war’ through government loans to fund war and territorial expansion.23 At the same time, though, public debt strengthened the political unity of the United States and also transformed its economy. As to the former, the widespread ownership of government bonds—although mostly among the American elites—helped to ‘cement’ the new nation, as bondholders, albeit through a selfish desire to be promptly repaid, had a stake in its success.24 On the economic side, the public debt created much needed new investment capital and increased the money stock.25 As US bonds appreciated in value, their holders—most notably merchants and banks—could reinvest their profits in productive new ventures.26 Banks could further use the new capital to support the issuance of bank notes, thereby limiting the chronic scarcity of cash in the economy.27 By pushing the tax burden into the future, public debt also minimized the economic distortions caused by high taxes.28 The US capital market increased by as much as 30–40 per cent, and by the 1820s it rivalled those of Britain and the Netherlands.29 The financial market also became much more sophisticated, as the establishment of a secondary market for government bonds opened the door to a whole set of new instruments, such as corporate equities and bonds.30 In short, the American economy not only grew but was also modernized. In retrospect, Republican aversion to deficit spending would seem fundamentally ill-conceived. As Hamilton predicted, sovereign debt became a blessing rather than a curse.

Of course, Hamilton’s fiscal policies are quite far from lending unqualified support to the accumulation of public debt by way of running chronic budget deficits. As already mentioned, the ultimate aspiration of both Federalists and Republicans was the restoration of US public credit. Above anything else, this required prudent fiscal policies and debt management. The US government also showed that it was prepared to go to great lengths in order to reassure the investor community of its creditworthiness. By 1795, when Hamilton submitted to the House of Representatives his ‘Report on a Plan for the Further Support of Public Credit’, he was of the view that the ‘progressive accumulation of debt’ constituted a ‘danger to every Government’.31 This report set up a clear path towards the repayment of foreign debt by 1809,32 an obvious departure from previous debt management practices that envisaged the public debt to be perpetual. In 1835, under the presidency of a Republican, Andrew Jackson, the totality of US public debt had been repaid. Nevertheless, this was largely made possible due to the restraining policies put in place by Alexander Hamilton, a man who firmly believed that the creation of a national debt would be key to American success.33

The lessons drawn from the history of US public debt as outlined above are perhaps too nuanced to fit into the polarized political debates that sovereign debt has historically sparked.34 Nevertheless, they should also be straightforward: sovereign debt undeniably
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constitutes an indispensable instrument of economic policy through its contribution to the generation of national wealth. At the same time, the distorted incentives it tends to create for policymakers make it one that should be managed with outmost prudence.35 Before turning to the main focus of this chapter, that is, the underlying reasons for sovereign debt crises, section 2.1.2 provides a (simplified) review of the economic literature on the effects of government deficit and debt on national income and growth. This literature is significant because it reveals the potential benefits of sovereign debt, but also because it offers some evidence that high levels of public debt often coincide with lower rates of growth, even in the absence of a full-scale sovereign debt crisis.

2.1.2 The economic effects of sovereign debt

Up until the publication of Keynes’ General Theory of Employment, Interest and Money in 1936, budget deficits carried a strong perception of stigma.36 While similar attitudes in the realm of private debt had already become obsolete by the late eighteenth century,37 the transition took more than an extra century in the sovereign context. According to the now mainstream view in economic theory, a distinction is made between the short and long-run effects of public debt. In the short run, public spending financed through debt and without tax increases raises aggregate demand in the economy and thus the national income.38 The merits of an activist fiscal policy are mostly acknowledged in situations of economic crisis where demand is suppressed.39

When the focus shifts to the long-run effects of deficit spending, however, the picture becomes different. Most economists would agree that the economic consequences of a continuously increasing public debt are adverse.40 This is generally attributed to the so-called crowding-out effect of debt, which essentially means that budget deficits result in lower levels of national savings, thereby reducing investment.41 In 2010, Carmen Reinhart and Kenneth Rogoff published their seminal paper on the relation between public debt, growth, and inflation. According to some observers, this paper was highly influential in providing the economic rationale for the support for austerity measures in both Europe and the United States.42 By surveying a database of more than forty-four developing and
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developed countries over a period of two hundred years, Reinhart and Rogoff found that median growth rates for countries with public debt of more than roughly 90 per cent of gross domestic product (GDP) are about one per cent lower than for others, while average (mean) growth rates are several percentage points lower.43 These findings proved to be extremely controversial and were later revised by the authors themselves.44

Most notably, in a 2013 paper, Herndon, Ash, and Pollin claimed that the Reinhart and Rogoff research ‘transformed the reality of modestly diminished average GDP growth rates for countries carrying high public debt levels into a false image that high public debt ratios inevitably entail sharp declines in GDP growth’.45 By recalculating the data provided by Reinhart and Rogoff, Herndon et al found that ‘the average real GDP growth rate over 1946–2009 for countries carrying a public debt-to-GDP ratio greater than 90 per cent is actually positive 2.2 per cent, not negative 0.1 per cent as Reinhart and Rogoff claim’.46

Overall, it seems that the case for the existence of a threshold level of public debt to GDP above which growth falls is far from certain.47 It is telling in this regard that the International Monetary Fund (IMF) has concluded that ‘there is no simple relationship between debt and growth … there are many factors that matter for a country’s growth and debt performance … there is no single threshold for debt ratios that can delineate the “bad” from the “good” ’.48

Beyond disagreement on the identification of clear thresholds above which the accumulation of public debt significantly inhibits economic growth, some economists have even argued that the causal relationship between higher public debt and lower economic growth is not supported empirically. After analysing data relating to a sample of Organisation for Economic Cooperation and Development (OECD) countries, Panizza’s and Presbitero’s answer to the question of whether ‘debt has a causal effect on economic growth’ is that they ‘don’t know’.49

At the same time, the correlation (as opposed to the causation) between increasing public debt-to-GDP ratios and slower economic growth does not seem controversial.50 Woo and Kumar have found that, on average, a 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown in real per capita GDP growth of around 0.2 percentage points per year.51 Without doubt, those findings offer policymakers a salutary warning against excessive debt accumulation.

The above short review of the economic literature has demonstrated that the question of the long-run effects of public debt on economic growth remains, to a large extent, unsettled. As will be explored in section 2.2.1, the role of budget deficits in the generation of
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sovereign debt crises is also more complicated than commonly suggested. Sovereign debt crises are complex phenomena and fiscal deficits are only one among multiple potential causes at their root.

2.2 Debt Crises: Why Do They Happen?

2.2.1 Budget deficits

In the conventional political narrative in Europe, the euro area’s sovereign debt crisis was mainly attributed to lack of fiscal discipline and excessive budget deficits.52 In the aftermath of the financial crisis, economists have identified an unprecedented increase in public debt across the world. At the end of 2013, public debt had reached an average of about 107 per cent of GDP in advanced economies, the highest level in fifty years.53 This rise in public indebtedness has been fuelled by consistent budget deficits: from 2008 to 2012, the advanced economies (as a group) ran overall deficits averaging more than 6.5 per cent of GDP per annum.54 To be sure, this does not merely reflect the bill of fiscal stimulus and financial sector bail-outs during the Great Recession. In fact, in the thirty years before 2008, budget deficits were the norm in both advanced and developing economies, although they were at historically low levels for at least a generation.55

Some commentators have argued that the main driver of these consistent budget deficits (at least as far as the pre-crisis years are concerned) has been a steady expansion of the welfare state and public services over the past twenty years.56 What is more, due to ageing populations in the Western world, the strain on public finances is only expected to rise if increased health, social care, and pension expenditures are factored in.57

Since a primary budget deficit is created either by increased spending and/or limited revenue, an inefficient tax administration is certainly another major factor behind the generation of large and consistent budget deficits. Tax avoidance and tax evasion have risen in the United States and everywhere in Europe since the Second World War.58 For countries such as Greece—the country that has suffered the most from the eurozone debt crisis—the size of the ‘grey’ economy has been a perennial malaise, as even before the crisis it stood at 24 per cent of GDP.59

As mentioned at the start of this section, the prevailing narrative in the political cycles of most eurozone capitals has been that the sovereign debt crisis in Greece, Ireland, Italy, Portugal, and Spain was due to fiscal profligacy in the countries of the European periphery. However, when tested against economic evidence, this describes only half of the picture. Of course, for countries such as Greece and Portugal, fiscal imbalances were certainly important in precipitating the debt crisis. Between 2000 and 2007, the Greek government ran an average budget deficit of close to 5.5 per cent of GDP.60 This corresponded to nearly three
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times the eurozone average and twice the maximum threshold of the Stability and Growth Pact (SGP).61 Even when looking at the primary fiscal balance (i.e. budget balance net of interest payments) over the same period, both Greece and Portugal ran deficits.62

But when one looks at the statistics for Ireland, Spain, and Italy, the picture is quite different: Ireland and Spain posted budget surpluses over the period 2000–7, whereas Italy had an average deficit below the 3 per cent SGP threshold.63 Ireland and Spain also entered the crisis with very modest public debt levels. In fact, Spain’s public debt-to-GDP ratio has been lower than the UK’s, despite the fact that at the height of the debt crisis the yield of the Spanish ten-year government bond was nearly four times higher than that of the UK.64 The history of the 2001 Argentine default was not one of excessive budget deficits either. In the ten years preceding the default, the average deficit was 1.2 per cent of GDP, whereas debt levels in 2001 stood at 55 per cent of GDP.65

As Manasse and Roubini note, sovereign debt crises are triggered by a mix of vulnerabilities, with high public debt-to-GDP ratios being only part of the equation.66 Even where sovereign debt crises have been precipitated by high levels of public debt, it is not clear that this is due to chronic fiscal deficits. According to Campos, Jaimovich, and Panizza, sovereign debt crises are mainly caused by ‘debt explosions’ (i.e. sharp and abrupt rises of public debt-to-GDP ratios), which have little to do with long-term budget deficits, but usually arise from contingent liabilities or inherent vulnerabilities in a country’s debt structure.67

Of course, the above hardly suggest that prudent fiscal policies are not an essential element of crisis prevention. After all, large macroeconomic imbalances, including structural budget deficits, have long been associated with sovereign debt crises.68 Greece’s unsustainable fiscal stance in the years prior to the crisis also suggests that politicians can indeed be amenable to the deficit bias identified at the beginning of this chapter. However, one ought not to lose sight of the fact that a sustainable fiscal balance, although necessary for the prevention of debt crises, might not be sufficient.69 In what follows, we examine more closely issues of contingent liabilities, sovereign debt composition, and creditor runs, all of which might have historically played a more important role in the eruption of sovereign debt crises compared to chronic budget deficits.

2.2.2 Contingent liabilities

As mentioned, sovereign debt crises are not commonly triggered by the incremental accumulation of public debt through steady budget deficits, but rather by virtue of destabilizing jumps in the public debt-to-GDP ratio (debt explosions).70 A major drive of such debt explosions is the so-called direct fiscal cost of systemic banking crises. To be sure, the sovereign’s ‘contingent liabilities’ may come in different shapes and forms. At the most basic level, a distinction is made between explicit and implicit sovereign guarantees. The former refers to obligations for which the sovereign has stepped into the shoes of the obligor
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through the assumption of primary responsibility for repayment.71 In most cases, obligors benefiting from such explicit guarantees will be certain state-owned enterprises.72 Implicit sovereign liabilities arise in situations where the primary obligor’s default can have broader systemic implications, and therefore the market has assumed that the sovereign would have to step in on its behalf. The focus here is on this latter category of contingent liabilities, which usually includes the direct fiscal cost of banking crises.

As recent experience with banking crises illustrates, the cost of contingent sovereign liabilities associated with the financial sector can be quite steep, even to the extent of threatening the sovereign’s own solvency. According to IMF calculations, in the period between 2007 to 2011, and in the midst of massive government intervention in the financial sector, the public debt of Ireland and Iceland increased by nearly 70 per cent of their GDPs; for Greece, the increase amounted to close to 40 per cent of the country’s GDP, while the same figures for Portugal and Spain were well above 30 per cent of GDP.73

The direct fiscal cost of financial sector rescues materializes in different ways: bank recapitalizations, asset purchases, calls on government guarantees, depositor payouts, or central bank recapitalization can potentially bring about considerable stress on the sovereign’s balance sheet.74 Apart from the direct fiscal cost of banking crises, the sovereign’s solvency can also be threatened by their indirect costs. Systemic banking crises usually lead to credit crunches, which exacerbate economic recessions, and therefore public revenues fall, with a corresponding increase in budget deficit and debt.75

Of course, the entanglement of sovereigns and banks in the context of financial crises could lead to bank failures as a result of exposure to an insolvent sovereign. As has been aptly put, governments and financial systems are, after all, communicating vessels.76 In this latter case, causality runs in the opposite direction, as sovereign debt distress and restructuring lead to negative consequences in the banking system. Greece is a case in point: as a result of the Greek state’s insolvency, Greek banks lost a third of their private sector deposits between 2009 and 2012, non-performing loans reached 36.6 per cent in late 2015, and the sovereign debt restructuring operation depleted their capital base.77 As a result, Greek banks have undergone three rounds of recapitalization since 2010, the last of which was in 2015, for a total of €43 billion.78

In acknowledgement of the destabilizing effects of spillovers between banks and sovereigns, and vice versa, breaking the ‘doom loop’ between them has been the linchpin of policy reforms relating to the creation of a banking union within the EU in the aftermath of the sovereign debt crisis. As analysed in more detail later in this chapter, both macroprudential financial regulation able to minimize vulnerabilities in the banking sector and effective
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resolution regimes are essential in preventing contagion across the financial system and between banks and sovereigns.

Finally, contingent sovereign liabilities (especially implicit ones) raise important challenges from the perspective of fiscal and financial accounts transparency. At one level, these challenges seem unavoidable, since implicit sovereign guarantees exist only in the eye of the beholder.79 Nevertheless, the IMF has stressed the importance of proper monitoring and risk assessment of implicit contingent liabilities from the perspective of public debt sustainability.80 It is telling that in this regard the IMF has found that ‘systematic attention to implicit contingent liabilities is lacking’, while ‘measuring risks to public debt from the financial sector is not adequately done prior to the materialization of risk’.81

2.2.3 Sovereign debt composition and creditor runs

Sovereign debt structures can pose a distinct, and in some instances quite significant, risk to sovereign debt management. There are two issues of particular importance in this regard: the debt’s currency of denomination and its maturity horizon. These two features can create vulnerabilities from the perspective of sovereign debt sustainability by creating currency and maturity mismatches.

A currency mismatch is created when the currency in which debts are denominated differs from the currency that the debtor earns revenues or has assets in.82 The origins of this problem are traced, inter alia, to the so-called ‘original sin’ in emerging economies. Original sin in this context is defined as the inability of a country to borrow abroad in its own currency.83 Due to original sin, developing countries have been historically able to access the international capital market only by issuing debt in foreign currency, thereby incurring currency mismatches.84

The detrimental effects of currency mismatches to sovereign debt sustainability become mostly apparent in cases of real exchange rate depreciations, whereby the purchasing power of domestic output over foreign claims is reduced, making it harder to service external debt.85 This dynamic was the main drive behind Argentina’s default in 2001. Over 2001 and 2002, Argentine public debt-to-GDP ratio increased from approximately 55 per cent to 150 per cent.86 The reason behind this debt explosion was Argentina’s abandonment of its dollar peg, which caused the local currency value of its dollar-denominated debt to quadruple.87 Under these circumstances, servicing the external debt on its original terms became impossible.

Interestingly, the countries of the eurozone caught in the region’s sovereign debt crisis might too have fallen victim to the adverse effects of foreign currency-denominated sovereign debt. In this regard, eurozone countries face challenges similar to those of emerging economies with a large share of foreign currency debt.88 Although technically issuing debt under their domestic currency, eurozone countries do not exercise any control over it. It is also important to clarify that the exercise of lender of last resort assistance functions by
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national central banks (NCBs) according to article 14(4) of the Statute of the European System of Central Banks remains a discretionary task, and NCBs must follow the rules and procedures established by the ECB.89

A maturity mismatch arises when there is a gap between the term structure of debts and the term structure and liquidity of the corresponding assets.90 If the amount of short-term debt exceeds that of liquid assets, a sovereign (or a bank or corporation, for that matter) becomes vulnerable to rollover risks and might have no other option than to restructure.91 Despite the threats it poses to debt sustainability, certain market dynamics are conducive to short-term funding. Short-term debt is usually cheaper than long-term, and therefore sovereign borrowers have an incentive to opt for the former.92 In addition, for risky sovereign borrowers, short-term debt might be the only available source of funding.93

For sovereign debtors funded predominantly through short-term debt, sudden stops in creditor confidence will likely lead to an immediate liquidity problem, and possibly to more fundamental concerns regarding solvency. The cases of Mexico and Russia in the 1990s are instructive in this regard. In 1994, Mexico suffered a major shock in investor confidence, partly due to domestic political and security upheavals.94 In order to calm investors concerned about the risk of devaluation, Mexico issued a large amount of short-term (in the area of ninety-one-day maturities) debt, indexed to the US dollar exchange value (tesobonos).95 By the end of 1994, Mexico had managed to avoid a default only through the concentrated intervention of the IMF and the US government.

The Russian default in 1998 tells a similar story. In the aftermath of the 1997 Asian financial crisis, investor sentiment towards Russian sovereign debt turned sour. As Porzecanski notes, an aggravating factor was the issuance of short-term government bonds (GKOs).96 This exposed the government to extreme rollover pressures and eventually led to the country’s default on GKOs in August 1998.

The adoption of best practices on sovereign debt management is therefore essential in avoiding risk-prone debt structures. According to the joint IMF–World Bank Public Debt Management Guidelines, ‘debt managers should carefully assess and manage the risks associated with foreign currency, short-term, and floating rate debt’.97

Still, even very prudent liability management would eventually fail to function as an effective safeguard in the face of a severe creditor run. The case of Greece is once more illustrative here. After the newly elected government announced a major upward revision of the budget deficit for 2009, Greece was very quickly precluded from refinancing its debt in the bond market.98 Apparently, the fact that the state had a very benign debt composition in the run-up to the crisis did not matter much.99 This underscores the significance of a lender of last resort as a credible backstop against (often self-fulfilled) creditor runs that could ultimately threaten a sovereign’s solvency.

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2.3 Policy Responses

This section outlines two of the major policy responses advanced to tackle the underlying reasons for sovereign debt crises within the EU framework. It focuses on the adoption of fiscal rules as a remedy to the accumulation of budget deficits and the creation of a banking union to break the negative feedback loop between banks and sovereigns. Of course, the following exposition does not aspire to offer a comprehensive account of policy responses that could reduce the risk of sovereign debt crises.100

2.3.1 Fiscal rules

A fiscal rule is a long-lasting constraint on fiscal policy through numerical limits on budgetary aggregates.101 Those aggregates usually refer to the budget balance, public spending, or government revenue.102 Fiscal rules might be contained in treaties, constitutions, legislation, or non-binding declarations.103 By design, they are instruments aimed at limiting what democratically elected governments can do in terms of spending, taxing, and borrowing.104 The rationale behind them is that, first, democratically elected governments are biased towards deficit spending,105 and, secondly, that formal legal constraints are able to function as effective disciplining devices.106

Experience with fiscal rules thus far is mixed. According to Wyplosz, fiscal rules are neither necessary nor sufficient in fostering fiscal discipline, but they can help.107 The major problem in this regard is one of credibility: any kind of rule is unworkable without the prospect that sanctions will be forthcoming in case of violation. Fiscal rules face the particular challenge that their addressees are governments, which are generally able to circumvent any self-imposed legal constraints.

The EU has had a long and bitter engagement with fiscal rules. The relevant institutional arrangements are surprisingly complex and fragmented, comprising provisions in the Lisbon Treaty (TFEU), the newly established Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG), secondary EU legislation, and high-level soft law.108 The key provisions of primary law are articles 121 and 126 TFEU and article 1 of the Protocol on the excessive deficit procedure annexed to the TFEU. According to the latter, fiscal discipline is assessed by way of two reference values: (a) 3 per cent for the ratio of the planned or actual government deficit to gross domestic product at market prices; (b) 60 per cent for the ratio of government debt to gross domestic product at market prices. The primary provisions are complemented by Regulations 1055/2005 and 1056/2005, commonly known as the SGP.109

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It is well known that the SGP’s compliance record has been rather disappointing. Over the first thirteen years of existence of the euro, the twelve initial member countries together satisfied the 3 per cent budget deficit limit only 60 per cent of the time.110 The credibility of the SGP suffered a major blow when the European Council failed to impose meaningful sanctions against Germany and France for not complying with the pact’s numerical thresholds.111 The failure of the two most powerful European states to comply with the SGP had a detrimental signalling effect to other EU countries, which felt they had received the green light to follow suit and disregard its provisions.

The failure of the SGP and the broadly held perception that the eurozone sovereign debt crisis was the consequence of budgetary profligacy in the countries of the European periphery brought the issue of fiscal discipline to centre stage from 2010 onwards. A number of new instruments were adopted, most notably the TSCG, in order to strengthen fiscal discipline by introducing more automatic sanctions and stricter surveillance.112 At the centre of the TSCG is the ‘balanced budget rule’, pursuant to which the budgets of the contracting parties should be balanced or in surplus.113 Further, the signatories undertake to give effect to the balanced budget rule in national law through provisions of binding force and permanent character, preferably constitutional, or otherwise guaranteed to be fully respected and adhered to throughout the national budgetary processes.114 This is to be enforced through article 8 of the TSCG, which allows contracting parties to have recourse to the Court of Justice of the European Union in cases where the balanced budget rule has not been properly implemented at the national level. A final provision of the TSCG that is worth mentioning because of its promise to anchor the new fiscal framework on a credible sanctions mechanism is article 7, which essentially provides for a reverse qualified majority voting rule. According to this, contracting states whose currency is the euro commit to support the EU Commission’s proposals where it considers that a eurozone member state is in breach of the deficit criterion in the framework of an excessive deficit procedure, subject to the qualification that this obligation does not apply if a qualified majority of such states oppose the proposed decision.115

To conclude, the jury is still out regarding the effectiveness of the revised EU fiscal policy framework. Ultimately, however, any fiscal rule is premised on the assumption that the tendency of democratically elected governments to produce deficits can be tempered through legal prescriptions. Historical experience with fiscal rules in both Europe and the United States, however, warrants that this should not be lightly assumed.116 More importantly, the adoption of fiscal rules—assuming that they indeed have a role to play in promoting fiscal responsibility—should be accompanied by reforms able to address the other root causes of sovereign debt crises. This is the subject of section 2.3.2, which focuses on the EU banking union.

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2.3.2 European banking union

The need for a European banking union emerged from the financial crisis of 2008 and the subsequent sovereign debt crisis. Of course, the combination of a strong monetary pillar with a loose economic and supervisory framework constituted a deep structural flaw in the original design of the European Economic and Monetary Union (EMU).117 Nevertheless, it was only after the financial crisis morphed into a full-scale debt crisis that the implications of the doom loop between banks and sovereigns became fully clear and bold policy action was seriously considered.118 As underlined by the Five Presidents’ Report on Europe’s Economic and Monetary Union in June 2015:

A single banking system is the mirror image of a single money. As the vast majority of money is bank deposits, money can only be truly single if confidence in the safety of bank deposits is the same irrespective of the member state in which a bank operates. This requires single bank supervision, single bank resolution and single deposit insurance.119

Those three elements—supervision, resolution, and deposit insurance—constitute the pillars upon which the banking union rests.120 The three pillars of the banking union are meant to function within a framework of substantive EU financial regulation regarding capital requirements for banks, management of bank failures, and a minimum level of protection for depositors, known as the ‘single rulebook’.121 While the first two pillars (bank supervision and resolution) have developed into sophisticated supervision and resolution frameworks at the European level, common deposit insurance remains a politically sensitive area, in which considerable action is still needed.122

With respect to bank supervision, the Single Supervisory Mechanism (SSM) seeks to safeguard that EU rules on prudential supervision are implemented coherently and effectively. Under the SSM Regulation, the ECB has become the competent authority for supervising directly ‘significant’ institutions, and indirectly the other ‘less significant’ institutions.123
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The SSM extends to all eurozone member states, while non-eurozone EU member states can participate in the SSM as long as they have established a ‘close cooperation’ in accordance with article 7 SSM Regulation.

The second pillar of the banking union is the Single Resolution Mechanism (SRM), which centralizes bank resolution authority within the EU. Given that, as will be explained later in more detail, the SRM entails an element of loss mutualization among its members, its establishment was a much more fraught process than that of the SSM. The SRM has two elements, the Single Resolution Board (SRB—an EU agency) and the Single Resolution Fund (SRF),124 and rests on two instruments, the SRM Regulation and the Bank Recovery and Resolution Directive (BRRD).125

The SRM’s aim is to ensure that financial institutions within the SSM area can be resolved according to common rules and pre-established procedures.126 The centralization of resolution authority within the SRM is achieved by granting responsibility for resolution decisions with respect to institutions supervised directly by the ECB and all cross-border groups to the SRB.127 The division of competences within the SRM is such that resolution decisions are implemented at the national level through the national resolution authorities.128 The decision-making procedure regarding the adoption of resolution schemes is governed by article 19 of the SRM Regulation. This process involves, inter alia, a determination by the ECB as to whether the entity which is subject to a resolution scheme ‘is failing or is likely to fail’, a decision by the SRB on which resolution tool(s) prescribed in articles 24–27 will be used, the scheme’s endorsement by the European Commission, and finally the potential involvement of the Council if the Commission so requests.129 According to the Commission, the article 19 procedure would allow a failing entity to be resolved within a weekend.130

Although this decision-making arrangement is certainly complex, and its application might not prove as swift as is hoped, it reflects exigencies imposed by primary EU law. In particular, under the Meroni doctrine, discretionary powers involving a wide margin of discretion cannot be delegated by an EU institution.131 Accordingly, given the SRB’s powers to place an institution in resolution and to construct a resolution scheme, and its subsequent operational powers, a Meroni challenge seems likely.132 The Commission’s ultimate authority to endorse a resolution scheme or object to its discretionary elements is therefore essential in insulating against such litigation risk.133

The SRF is another crucial feature of the SRM. The SRF is financed through contributions from the financial institutions that are subject to the SRM and its purpose is to provide the necessary funds for the implementation of a resolution scheme. Quite evidently, by providing that the costs of resolution are borne by the financial industry and not national budgets, the SRF is crucial in breaking the negative feedback loop between bank and sovereign stress. While, during the initial ten-year period in which the SRF is to build its reserves, the contributions of financial institutions are nationally ‘compartmentalized’ in order to be used only for the resolution of banks in the respective member state, the SRF will be
(p.43)
eventually merged and mutualized.134 As mentioned, this will allow for the mutualization of losses among the SRM’s members, which signifies a historic breakthrough.135

From the outset, the establishment of the European banking union was meant to function within a broader architecture aiming to break the entanglement between failing banks and sovereigns in the euro area. This architecture also includes, as its fiscal backstop, the European Stability Mechanism (ESM), with the capacity to directly recapitalize ailing eurozone banks. Since the SRM became fully operational, bank recapitalization has not been premised solely on public (if supranational) funds, but encompasses an element of burden sharing. Access to ESM recapitalization funds is therefore an option only in the event that private capital resources have been engaged first, including by way of the bail-in tool.136 Of course, this hardly provides for a perfect separation of bank and sovereign balance sheets.137 It is equally certain, however, that this should not be the banking union’s measure of success. All too often bail-ins and bail-outs represent not a binary choice, but parts of the same strategy to address systemic risk.138 To the extent that the bank–sovereign link needs to be weakened, though (as it surely does), the banking union certainly goes a long way in this direction. Beyond providing a credible crisis resolution framework ex post through the SRM, the SSM could have prevented the concentration of risk in the banking sector in countries such as Cyprus, Ireland, and Spain,139 thereby further loosening the bank–sovereign link that was at the centre of the eurozone sovereign debt crisis.

2.4 Conclusion

This chapter has argued that policy responses to sovereign debt crises need to be calibrated so as to take account of the individual factors at play each time. This means that policy action should be flexible and that a ‘one size fits all’ approach will fail. The eurozone sovereign debt crisis has posed a distinct challenge, in the sense of being a single yet multifaceted episode. As previously argued, while the proximate causes of the crisis were different in the various countries of the European periphery, the importance of deeper structural flaws in the design of the European EMU cannot be overemphasized. This diagnosis necessarily calls for policy action on multiple fronts, something that—albeit with considerable delay—was eventually (and is still being) pursued. In this context, we have focused on policy reforms in the areas of fiscal rules and the banking union. While not underestimating the importance of fiscal discipline as a necessary condition for sovereign debt sustainability, we are sceptical about the potential for fiscal rules to achieve their declared objectives. Nevertheless, to the extent that the new European fiscal framework is to be accompanied
(p.44)
by credible commitment mechanisms, it is certainly welcome. On the other hand, the completion of the European banking union promises to be a much more consequential reform. This view traces the economic literature in ascribing paramount importance to debt explosions precipitated, inter alia, by large sovereign contingent liabilities as a major cause for the eruption of sovereign debt crises.

Notes:

(1)
Max M Edling, ‘So Immense a Power in the Affairs of War: Alexander Hamilton and the Restoration of Public Credit’ (2007) 64 William and Mary Quarterly 287, 316.

(4)
This is what is commonly referred to as the ‘deficit bias’. It corresponds to ‘the tendency to push out the discipline burden to future governments or even to future generations’. The bias towards fiscal deficits is also explained by the ‘interplay of democratic processes and interest group politics. Politicians enhance their (re)election probabilities by catering to interest groups and providing public largesses, at the expense of future taxpayers’. See Charles Wyplosz, Fiscal Rules: Theoretical Issues and Historical Experiences, NBER Working Paper No 17884 (March 2012) 5. For a criticism of the deficit bias school of thought, see Alasdair Roberts, ‘No Simple Fix: Fiscal Rules and the Politics of Austerity’ (2015) 22 Indiana Journal of Global Legal Studies 401, 404–8 (arguing that the theory is premised on a fundamental mistrust of democratic processes).

(10)
As Hamilton put it, ‘it seems to be a clear position, that when a public contracts a debt payable with interest, without any precise time being stipulated or understood for payment of the capital, that time is a matter of pure discretion with the government, which is at liberty to consult its own convenience respecting it, taking care to pay the interest with punctuality’. Ibid. In fact, the government’s discretion as to the securities’ redemption was restricted. Ibid 312.

(17)
For a discussion of the challenges to sovereign autonomy in the context of modern sovereign debt governance, see Anna Gelpern, ‘A Skeptic’s Case for Sovereign Bankruptcy’ (2013) 50 Houston Law Review 1096, 1099–1100.

(18)
Of course, as mentioned previously, this was not always the case: both domestic and foreign creditors had to forego the original terms of the debt by accepting lower interest payments.

(19)
Cited in Jonathan Stone, Jeffrey Wagner, ‘Fairness and Efficiency in US Revolutionary War Takings and Post-War Debt Redemption’ (2016) 27 Constitutional Political Economy 399, 403. For an account of modern conceptions of inter-creditor equity in sovereign insolvency, see Vassilis Paliouras, ‘Inter-Creditor Equity in Corporate and Sovereign Debt Restructuring’, Völkerrechtsblog, 1 February 2017.

(20)
Stone and Wagner (n 19) 401, mentioning that ‘American soldiers were paid predominantly in promissory notes, while at the same time the American military funded itself in large part by either exchanging certificates for the property of civilians, oftentimes directly confiscating or “impressing” the property when civilians were unwilling to trade at the established prices’.

(21)
Madison even claimed that the US government’s obligation to compensate the original bondholders was such that ‘if a tribunal existed on earth, by which nations could be compelled to do right, the United States would be compelled to do something not dissimilar in its principles to what I have contended for’. Cited in ibid at 402.

(22)
In defending the right of secondary market creditors to full repayment, Hamilton claimed: ‘The nature of the contract in its origin, is, that the public will pay the sum expressed in the security, to the first holder, or his assignee. The intent, in making the security assignable, is that the proprietor may be able to make use of his property, by selling it for as much as it may be worth in the market, and that the buyer may be safe in the purchase.’ Cited in ibid at 403.

(23)
In fact, one could not overemphasize its role as such. After 1780, America adopted a more aggressive policy not only towards Indian nations but also against European states. Edling (n 1) 299.

(24)
Robert E Wright, One Nation under Debt: Hamilton, Jefferson, and the History of What We Owe (McGraw-Hill 2008), 14. This was the other side of Jefferson’s argument about the creation of a ‘political constituency’ of bondholders (n 16).

(37)
On that point, Bruce Mann notes that within the framework of the eighteenth-century ‘moral economy of debt’ in the United States, ‘inability to pay was a moral failure, not a business risk. Like other moral failures, such as fornication or drunkenness, it called forth sanctions that to modern eyes were disturbingly punitive’. Accordingly, ‘the dependence of debtors and the omnipotence of creditors’ was presupposed and inevitable. However, the gradual move of the United States from a moral economy of debt to a modernized commercial society marked a major change of attitudes towards debt and insolvency, as evidenced by the first (though short-lived) Federal Bankruptcy Act of 1800. Bruce Mann, Republic of Debtors: Bankruptcy in the Age of American Independence (Harvard University Press 2002) 3–4.

(49)
Panizza and Presbitero (n 47) 36. The authors also mention that things may be different in developing economies where a large fraction of debt is external. Their findings were criticized in Jaejoon Woo, Manmohan Kumar, ‘Public Debt and Growth’ (2015) 82 Economica 705, 707.

(51)
Woo and Kumar (n 49) 729, noting that the impact is smaller in advanced economies.

(52)
Philip R Lane, ‘The European Sovereign Debt Crisis’ (2012) 26 Journal of Economic Perspectives 49, 56 (noting that the revelation that the Greek budget deficit had been forecast to stand at 12.7 per cent of GDP rather than 6 per cent shaped an influential political narrative of the crisis according to which fiscal irresponsibility was its main cause).

(56)
Mary Dowell-Jones, ‘The Sovereign Bond Markets and Socio-Economic Rights: Understanding the Challenge of Austerity’ in Eibe Riedel, Gilles Giacca, and Christophe Golay (eds), Economic, Social, and Cultural Rights in International Law (Oxford University Press 2014) 56. See also Willem Buiter, Ebrahim Rahbari, ‘Why Governments Default’ in Lastra and Buchheit (n 35) 269 (mentioning increased demand for public spending especially since the end of the Second World War).

(71)
Such an explicit sovereign guarantee might take the following form: ‘The Republic hereby unconditionally and irrevocably guarantees (as primary obligor and not merely as surety) the punctual payment when due, whether at stated maturity, by acceleration or otherwise, of all obligations of the Obligor now or hereafter existing under this Agreement.’ Cited in Lee Buchheit, G Mitu Gulati, ‘Sovereign Contingent Liabilities’ in Lastra and Buchheit (n 35) 241.

(74)
Ibid, 16. For a detailed account of rescue measures within the EU in the aftermath of the financial crisis, see European Central Bank, National Rescue Measures in Response to the Current Financial Crisis (Legal Working Paper No 8/July 2009).

(83)
Barry Eichengreen, Ricardo Hausmann, Ugo Panizza, Currency Mismatches, Debt Intolerance and Original Sin: Why They Are Not the Same and Why It Matters (2003) NBER Working Paper No. 10036, at 3.

(84)
Porzecanski (n 35) 315. There is evidence, however, that in the past twenty years emerging economies have been able to considerably increase the proportion of their domestic (i.e. local currency) debt. See Frieda (n 55) 293–4.

(85)
This is known as the ‘balance sheet effect’. See Eichengreen et al (n 83).

(97)
IMF–World Bank Revised Guidelines for Public Debt Management (March 2014), 8, 27, noting that ‘In the absence of compelling evidence that the government has significant direct revenues or assets denominated in foreign currencies, debt management strategies that include an over-reliance on foreign currency or foreign currency indexed debt and short-term or floating rate debt are very risky. For example, while foreign currency debt may appear, ex ante, to be less expensive than domestic currency debt of the same maturity (given that the latter may include higher currency risk and liquidity premia), it could prove to be costly in volatile capital markets or if the exchange rate depreciates.’

(99)
As of end-2009, only 10 per cent of Greek government debt had a residual maturity of less than one year. Porzecanski (n 35) 320.

(100)
By way of illustration, other relevant policy action would include the following: scrapping the risk-free regulatory treatment of sovereign debt in order to reduce incentives to over-lend; the use of equity-like government debt (see generally Stephen Kim Park, Tim R Samples, ‘Towards Sovereign Equity’ (2015–16) 21 Stanford Journal of Law, Business and Finance 240); avoiding risky debt structures by following best practices on sovereign debt management).

(109)
Council Regulation (EC) No 1055/2005 of June 27 2005 amending Regulation (EC) No 1466/97 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies and Council Regulation (EC) No 1056/2005 of June 27 2005 amending Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of the excessive deficit procedure. For a comprehensive analysis of these instruments see Rosa M Lastra, International Financial and Monetary Law (2nd edn, Oxford University Press 2015) 301 et seq.

(114)
Article 3(2) TSCG. This wording creates a loophole through which the contracting parties can comply with the provision even without any statutory measure at the national level, as long as they can make a case that the balanced budget rule is ‘fully respected and adhered to throughout the national budgetary processes’. Craig (n 108) 237.

(118)
The commitment to establish a centralized system of bank supervision and resolution was announced on 29 June 2012 by the European Council and Eurogroup member states. See euro-area summit statement, 29 June 2012 and European Council, remarks by President Van Rompuy, 29 June 2012.

(120)
As has been argued elsewhere, a true banking union requires a fourth pillar: the ECB acting as a genuine lender of last resort. See Lastra (n 109) 376.

(121)
The relevant instruments of the single rulebook in the post-crisis era are: Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (Capital Requirements Directive IV); Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (Capital Requirements Regulation); Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No 1093/2010 and (EU) No 648/2012, of the European Parliament and of the Council (Bank Recovery and Resolution Directive; BRRD); Directive 2014/49/EU of the European Parliament and of the Council of 16 April 2014 on deposit guarantee schemes (Deposit Guarantee Scheme Directive).

(122)
In November 2015, the European Commission introduced a legislative proposal for a European Deposit Insurance Scheme (EDIS). The EDIS would develop over time and in three stages, with a full European system of deposit guarantees envisaged for 2024. European Commission Fact Sheet, ‘A European Deposit Insurance Scheme (EDIS)—Frequently Asked Questions’. Available at: <http://europa.eu/rapid/press-release_MEMO-15-6153_en.htm>.

(123)
Article 6(4) Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions (SSM Regulation).

(125)
Regulation (EU) No 806/2014 of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund and amending Regulation (EU) No 1093/2010; BRRD (n 121).

(135)
Moloney (n 124) 1644, 1658 (mentioning Germany’s opposition to mutualization of resolution costs through article 114 TFEU, which eventually led to the adoption of a separate intergovernmental agreement).

(136)
Private sector contribution for direct ESM recapitalization requires: a bail-in equal to an amount of not less than 8 per cent of total liabilities including own funds of the beneficiary institution; a contribution of the resolution financing arrangement of up to 5 per cent of total liabilities including own funds; a write-down or conversion in full of all unsecured, non-preferred liabilities other than eligible deposits (excluding certain types of liabilities listed in the BRRD). See <https://www.esm.europa.eu/assistance/lending-toolkit>.

(138)
Adam Levitin, ‘In Defense of Bailouts’ (2010–11) 99 Georgetown Law Journal 435, 439 (arguing that ‘Any prefixed resolution regime will be abandoned whenever it cannot provide an acceptable distributional outcome. In such cases, bailouts are inevitable’); Emilios Avgouleas, Charles Goodhart, ‘Critical Reflections on Bank Bail-Ins’ in Antonio Segura Serrano (ed), The Reform of International Economic Governance (Routledge 2016) 59–60 (‘unless the risk is idiosyncratic or in the event of a systemic crisis, bail-in regimes will not remove the need to inject public funds’).

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